WASHINGTON — Nothing about the Basel II capital rule has been simple, and its latest flaws, exposed by massive losses in the mortgage market, have further divided regulators.
In one corner is Federal Deposit Insurance Corp. Chairman Sheila Bair, who has long warned of the dangers of relying on banks' internal models to set capital requirements. She is advocating applying the brakes while regulators address Basel II's problems.
"I question whether we should be moving to implement this year, given all the other challenges the banking industry faces and the uncertainty that Basel II implementation would have on capital levels," Ms. Bair said in an interview Monday. "I question whether the models are a reliable gauge for setting capital adequacy. … We should be extremely cautious."
In the other corner, Gov. Randall Kroszner of the Federal Reserve Board and Comptroller of the Currency John Dugan said implementation should proceed while regulators around the globe consider revisions.
"Basel II is an ongoing process," Mr. Kroszner said. "I don't think anyone thought we'd never have to adapt to new information and market movements. … Any risk-based framework has to be a living organism."
Mr. Dugan said changes are intended to enhance Basel II, not overhaul it.
"We have always said it's not perfect and should be adjusted continually to address issues that arise," he said. "So I would not call the changes under discussion a move away from Basel II, but rather an effort to significantly strengthen and improve it."
Regulatory divisions are nothing new for Basel II. Until mid-2007 supervisors appeared to be at an impasse over whether to mandate a straight equity-to-assets leverage ratio and whether to let the largest banks follow a less complex version of the rule. Only after congressional pressure intensified that summer did Fed Chairman Ben Bernanke and Ms. Bair hash out an agreement that was ultimately adopted.
As regulators prepare for a new round of negotiations, Mr. Dugan said he is confident the crisis atmosphere will encourage agencies to cooperate.
"Again, we are not trying to fundamentally overhaul Basel II, but to make significant enhancements," he said. "Given all that's occurred, I think the climate has changed to support such enhancements, despite some of the difficulties we've faced in the past."
As it is, the implementation process for Basel II is far from complete. Institutions with more than $250 billion of assets were required to submit plans to their boards by Oct. 1 detailing how they would comply with the rule. Once the plan is finalized, the banks have until April 1, 2011, to complete four consecutive quarters of a "parallel run" in which they comply with Basel I capital requirements but calculate Basel II capital levels simultaneously.
The list of banks required to adopt Basel II is also in flux. PNC Financial Services Group Inc.'s purchase of National City Corp. brought it over the threshold for being a "core" institution that must follow Basel II. Also, the Washington Mutual Inc. failure and Wachovia Corp.'s to Wells Fargo & Co. took two institutions off the list.
Still, most observers expect the financial crisis to result in big changes to Basel II this year. In November the Basel Committee on Banking Supervision, an international organization of central banks, outlined eight "building blocks" for strengthening the rule. They include broadening the risk captured by Basel II and enhancing the quality of Tier 1 capital.
Industry representatives expect sweeping revisions.
"I would think everything is fair game at this point, given the problems the industry has encountered," said Mark Tenhundfeld, the senior vice president of regulatory policy at the American Bankers Association.
More capital is likely to be required behind off-balance-sheet assets and trading books.
"We need to think very carefully about risk management and … strengthening the capital requirements in the trading book and strengthening focus on off-balance-sheet exposures," Mr. Kroszner said.
Mr. Dugan said he expects guidance this quarter from the Basel Committee on managing the trading book.
"Those trading book requirements have not changed significantly since 1996," he said. "There are now ongoing efforts to fundamentally revise the capital requirements for trading book assets."
Ms. Bair said regulators could "individually tackle discreet issues, such as holding capital against off-balance-sheet assets," but she also signaled that a more comprehensive look is necessary.
"I think we should step back and take a long, hard look before we proceed to further implementation," she said.
Another issue ripe for reconsideration is liquidity risk management. Capital adequacy is always a concern for bankers, but a sudden loss of liquidity doomed several institutions last year.
"I would argue that the greatest challenge in the last year, both for institutions and their supervisors, has been liquidity strains caused by a range of factors, such as the severe slowdown in the securitization markets, concerns with off-balance-sheet assets, and valuation problems," Mr. Dugan said.
Ms. Bair is not the only regulator with qualms about Basel II. Thomas Hoenig, the president and chief executive of the Federal Reserve Bank of Kansas City, warned in a November speech that Basel II could still result in capital holdings that are too low.
"I am most concerned that any institution that tends to underestimate its risk exposure — as many recently have — will be just as likely to underestimate its capital needs if allowed to operate a risk-based capital standard, such as Basel II," Mr. Hoenig said. "Risk-based capital standards may also encourage institutions to lower their capital, instead of build it up, in the prosperous times that typically precede a crisis."
Raising further doubt, many observers say the version of Basel II that was finalized in the United States would have done little to curb the industry's risky practices that caused the financial crisis. They cite an overreliance on internally generated models that were far too optimistic and would not have required enough capital.
"The current Basel II rule as it is today would not have prevented the crisis," said Hugh Kelly, a principal in the financial risk management practice at KPMG LLP and a former Office of the Comptroller of the Currency official. "You have to question the current approach to some risk structures and whether there was an overemphasis on quantification and modeling and not enough emphasis on fundamental risk management issues. To me, if you were to look back, the big lesson learned in my mind is a failure in risk management principles."
Ms. Bair said that the situation could have been worse if Basel II had already been implemented.
"The quantitative impact studies show significant drops in capital against significant mortgage exposures," she said. "Early implementation could have put us in a much worse position."
One glimmer of hope for bankers could be less concern about competition with foreign companies.
For years bankers in the United States — and some members of Congress — fretted that other countries would implement less strenuous versions of Basel II, allowing foreign banks to hold less capital and perhaps giving them a competitive edge in global markets. But now governments in both the United States and Europe have injected capital into their banks, and European leaders have signaled that they intend to toughen Basel II provisions there. Central bankers in Switzerland, for example, have indicated support for instituting an equity-to-assets leverage ratio — a provision that was the subject of much consternation in the United States.
Still, the financial crisis has demonstrated the difficulties of global regulation.
Though many countries look to the guidance offered by the Basel Committee, they can still implement the capital rules as they wish. Despite concerns over national sovereignty, some observers question whether the Basel Committee should have more authority.
"The Basel Committee has done a good job teeing up the issues, but it doesn't have any authority," Mr. Kelly said. "The crisis really begs the question of whether more can be done."
Karen Shaw Petrou, managing director of Federal Financial Analytics Inc., said the committee will have to move more swiftly this year to maintain relevance.
"It took a full 10 years to move the [Basel II] rules, because of the consensus process, which is always awkward, because of the deliberations and the wine at dinner," she said. "That's over for the foreseeable future."
